A Research Program on the Interplay Between Entrepreneurial Activity and Tax Policy

People have produced
such amazing products during the past few years that it is easy to
forget that, after their unveiling, machines such as the printing
press and the steam engine were viewed with just as much awe as the
microprocessor is today. Yet what is clumsily referred to as
"technological innovation" has consistently led to
controversy as new products and processes replaced old
ones-even in the 1400s. This dynamic process, central to the
functioning of a market economy, was termed "creative destruction"
by 20th century economist Joseph Schumpeter.

From the earliest
days, the "destruction" portion of this dynamic process has brought
into question government's proper role in a market economy. For
instance, how far should policymakers go to "protect" the
hand-copiers that the mechanical printing press would displace? To
what extent should government implement policies to encourage
entrepreneurs to invent the printing presses of tomorrow?
These questions have been asked for centuries, but the answers
still remain a source of debate.

Throughout U.S.
history, most policy geared toward encouraging entrepreneurs has
been passive. Instead of actively encouraging entrepreneurs
with direct subsidies, U.S. policymakers have typically used
government power to provide the laws and the institutional
framework needed for individuals to run their own businesses.
There is little doubt that much of America's economic well-being
has resulted from this relationship.

For instance,
Microsoft, General Electric, and Ford Motor Company were started by
a handful of individuals with the government-guaranteed right to
keep most of what they could earn from their innovations.
Interestingly, these companies' successes have led many
policymakers to pursue a more active role in encouraging
entrepreneurial activity. Therefore, most current policy
debates revolve around which active policies-e.g., targeted
tax breaks, loan guarantees, and subsidies-work best. However, even
tax policy can be viewed as a passive approach for encouraging
entrepreneurial activity.

If all taxpayers pay
the same income tax rate- regardless of the source of that
income-then government policy is not giving preferential tax
treatment to any one type of income. In this case, tax law
passively encourages business activity by not providing tax
incentives for (or against) starting a business. This paper
provides a discussion of the research issues surrounding the impact
that tax policies have on entrepreneurial activity.

Research
Issues

On a theoretical
level, judging how effectively tax policy influences business
activity is not always straightforward. Measuring a successful
outcome requires a clear definition of a policy's objectives.
Simply stating that a policy's aim is to "encourage
entrepreneurship does not provide an easily measurable
objective because it relates to individuals' states of mind.[1] Even
trying to measure such an objective using "increased employment,"
"increased startups," or "higher individual wealth" can be
problematic.

Changes in
employment are difficult enough to measure, but the newly
self-employed present an interesting problem because, by
definition, they do not work for another company. Consequently,
even if a policy does cause individuals to leave their jobs and
start their own companies, the net change in employment could-at
least initially- be zero. Furthermore, when individuals start new
businesses, their ultimate success or failure will likely remain
unknown for several years.

Measuring success
for those startup ventures that do last several years presents a
problem similar to that of measuring employment. A measure of
success for these long-lasting startups has to consider
whether this business activity would have taken place in the
absence of these particular companies. For instance, if Mr.
Jones starts a new maid service company, a near-term measure of
success has to consider any lost customers from Mr. Jones's
competitors. Additional research difficulties, such as determining
whether entrepreneurial activity increases the wealth of the
business owners, are data-driven problems.

Data
Sources

The most significant
data problem in studying entrepreneurial activity is a lack of
data. Although there are several data sources for studying
demographic characteristics of small-business owners, the data
needed to address most business-related tax policy issues are
sparse. The following sections summarize the major data sources
used to study business activity, and they provide brief
descriptions of the strengths and weaknesses that each data
set offers tax policy researchers.[2]

Statistics of
Income. The Statistics of
Income (SOI) division of the Internal Revenue Service (IRS)
produces an annual Public Use Tax File that contains over 130,000
records. The SOI database is a statistically representative sample
of all U.S. individual income tax returns for any given year. The
data consists of virtually all major items that taxpayers provide
on their returns, such as filing status, number of dependents,
amount of deductions, amount of income from various sources
(wages, dividends, etc.), adjusted gross income, and taxable
income. Because the SOI file contains individual income tax
data, the only business-related data in the file are what business
owners report on their individual income tax returns.

For example, sole
proprietors are required to file IRS form Schedule C; therefore,
business income reported on Schedule C is in the SOI file.
However, Schedule C contains roughly 50 line items and not all
of the Schedule C information is included in the SOI file. For
example, the SOI file does not include a separate total for repairs
and maintenance expenses, but it does include a separate
amount for wage expenses and for total expenses. Similar
problems-and in some cases, more severe-exist regarding business
information from other types of business entities, such as S
corporations and limited liability companies (LLCs). In any
event, the file does not contain important business information,
such as the number of employees and cash on hand. Additionally, the
annual releases cannot be used to track the same business owners
across successive years.

For well-funded
researchers, purchasing a longitudinal SOI file from the
University of Michigan's Office of Tax Policy Research (OTPR) can
mitigate this last problem. Michigan's OTPR has worked with the SOI
to create a "panel" of tax return data that provides researchers
with tax return data on the same taxpayers from 1979 to
1990. In addition to the public use file and the OTPR panel, the
IRS posts on its Web site a limited amount of business-related data
(taken from individual tax returns), as well as various aggregated
tax information in the Statistics of Income Corporation Source
Book.[3] However, because these data are already
aggregated, they typically cannot be linked to individual
taxpayers. Below are the strengths and weaknesses of the tax
databases research:

Strengths: Provides
a rich data source for information on U.S. individual income
tax returns.

Weaknesses: Provides
only limited business activity data.

Panel Study of
Entrepreneurial Dynamics. The Panel Study of
Entrepreneurial Dynamics (PSED)[4] is coordinated by the
University of Michigan's Institute for Social Research. The PSED is
a longitudinal sample of nascent entrepreneurs and is
uniquely designed. The "panel" consists of 830 individuals actively
engaged in starting new businesses. Importantly, it tracks these
same individuals for two years following their startups. In other
words, the PSED contains three years of data on new entrepreneurs,
and the first year of data covers the first year that the business
existed.

The PSED is the
first U.S. database to offer longitudinal data that can be
used to describe the characteristics of individuals engaged in the
process of starting a business. Most of the data in the PSED
relates to social characteristics and demographics. For
example, the nascent entrepreneurs report age, gender, ethnicity,
education level, family composition, income, and net worth.
Additionally, the PSED contains data that may explain personal
preferences for starting a business, such as family business
background, work history, and business climate perceptions. The
PSED does collect some data directly concerning policy issues,
such as whether or not (and what type of) public assistance
programs were used to start the business venture, but the bulk
of the data consists of social and demographic
characteristics.

Because the PSED
examines startup ventures, most financial data relate to the
owners' projections rather than actual values. For instance,
many startups do not have any sales (or even a marketable
product) for the first few years of existence. Similarly, although
the PSED does contain information on initial funding sources,
judging the need for additional funds and/or financial
assistance initially depends on the owners' projections.
Finally, the PSED is not designed to study specific tax policies
and, as such, does not ask nascent entrepreneurs to report any
detailed tax information. Below are the strengths and
weaknesses of the PSED research:

Strengths: Offers a
wide array of social and demographic characteristics for
individuals engaged in starting business.

Weaknesses: Contains
very limited tax-related data; does not collect a robust set of
business data from going-concern entity owners; and includes a
relatively small sample size.

Survey of Business
Owners and Self-Employed Persons. The U.S. Census
Bureau conducts the Survey of Business Owners and
Self-Employed Persons (SBO) every five years, and the latest survey
contains data from 2002. The SBO contains business owners'
demographic information, such as the gender, race, age,
ethnicity, and educational level, as well as economic data such as
primary business function, types of customers, types of workers,
source of startup capital, and source of financing for capital
improvements.

However, the SBO
questions are rather general in nature, and business-owner data are
not released to the public. For example, the survey does not ask
for the amount of startup capital or the dollar amount of capital
improvements made in a given year. Similarly, the SBO asks whether
workers are full-time or part-time employees, but it does not ask
how many are employed. Finally, the SBO does not contain any income
or tax-related data. This survey was previously conducted as
the 1997 Economic Census Surveys of Minority-Owned Business
Enterprises and Women-Owned Business Enterprises.[5] Below are the
strengths and weaknesses of the SBO research:

Strengths: Provides
a wide range of social and demographic characteristics of business
owners.

Weaknesses: Data are
collected only every five years, and only aggregate-level data are
released to the public.

Longitudinal
Business Database. The
Longitudinal Business Database (LBD)[6] is a dataset constructed
by the Bureau of the Census' Center for Economic Studies. It is not
publicly available. The LBD is a longitudinal database that follows
individual businesses (with paid employees) from 1975 to 1999.
The LBD is principally used to study trends in industry entry and
exit, gross job flows, and overall changes in the structure of the
U.S. economy.

These data are
complied from a variety of sources, such as the federal Business
Register, the Economic Censuses, and various surveys.
Information in the LBD is collected at the establishment
level-meaning that companies with multiple locations are treated as
multiple establishments. Even though the file attempts to
"link" establishments over roughly 25 years, most of the
establishments in the LBD remain in the data for only a few
years.

As is the case with
most business-related Census Bureau surveys, the LBD tends to
gather general information on payroll, employment, and sales, but
does not gather detailed tax and income information on
individual business owners. Below are the strengths and weaknesses
of the LBD research:

Strengths: Contains
business data for the same business establishments across multiple
years.

Weaknesses: Does not
include detailed tax and income information about individual
business owners.

Current Population
Survey. The Bureau of the
Census conducts the Current Population Survey (CPS)[7] for the Bureau of
Labor Statistics (BLS). The CPS surveys about 50,000 households
each month, and it is the primary source of information on labor
force characteristics for the U.S. population. (The CPS data
are used to produce the monthly BLS Employment Situation report.)
The sample provides estimates for the nation as a whole and serves
as part of model-based estimates for labor force characteristics in
individual states and other geographic areas.

The CPS collects
data on income, employment, unemployment, earnings, hours of work,
and a variety of demographic characteristics including age, sex,
race, marital status, family structure, and educational attainment.
Information reported in the CPS also allows researchers to sort
data by occupation and industry, and supplemental questions
are frequently added to study timely topics, such as employee
benefits and health plans. However, the CPS does not collect
detailed business information, such as sales, capital expenditures,
and asset size. Additionally, specific tax data items-such as
Schedule C wage expenses and taxable income-are typically not
included in the CPS. Below are the strengths and weaknesses of the
CPS research:

Strengths: Contains
a wealth of income and demographic information for a nationally
representative sample of U.S. households.

Weaknesses: Does not
gather detailed information about business establishments and
does not provide a large sample of business owners.

Longitudinal
Employer-Household Dynamics. The Longitudinal
Employer-Household Dynamics (LEHD), also know as the Local
Employment Dynamics,[8] is conducted by the Census Bureau. The LEHD
survey collects data on increases and decreases in employment on a
quarterly basis in 10 states.[9] The LEHD is compiled using
state unemployment insurance wage records and the Department of
Labor's ES202 data.[10]

The LEHD's main goal
is to provide its partner states with improved data on changes in
workforce composition. The establishment-level LEHD data are not
publicly available, and detailed business information such as sales
revenue, profit, capital expenditures, and funding sources are not
collected. Below are the strengths and weaknesses of the LEHD
research:

Strengths: Provides
employment data for the same business establishments across
multiple years.

Weaknesses: The
survey is not conducted nationally and the results are not publicly
available.

VentureXpert.
Thomson
Financial's VentureXpert database is a main data source for
researching the private equity industry. For example, the
database contains information on initial public offerings
(IPOs), venture capital deals, buyouts, and limited partnerships
around the world. Most of the data included in VentureXpert are
time-series data, such as the number and sizes of deals completed
for a given month and the number and share prices of IPOs in a
given quarter. Below are the strengths and weaknesses of the
VentureXpert research:

Weaknesses: Because
it is primarily a financial market database, it contains virtually
no information about business owners and does not track
business activity.

Public Financial
Records. Publicly traded
corporations are required to file annual financial reports
with the Securities and Exchange Commission, and these reports
are a matter of public record. These reports contain a wealth of
financial accounting data-such as asset size, sales volume, debt,
and cash flow-but they do not contain information from these
companies' tax returns. (Tax returns are considered private
information.) Most publicly traded corporations are owned by more
than just a few individuals, and most are quite large in terms of
assets, sales volume, and/or number of employees.

Data collection from
these reports can be quite tedious because each company's report
contains only information for that particular company.
Furthermore, public companies report financial
information based on Generally Accepted Accounting Principles.
Because not all businesses operate in an identical manner, these
rules offer companies leeway with many reporting choices. Some
of these problems can be overcome by purchasing Standard and
Poor's Research Insight database; a product that
"standardizes" financial statement data from virtually all publicly
traded companies. Additionally, corporate income tax
simulation models can be created by combining data from the
Research Insight database with tax data from the Statistics of
Income Corporation Source Book. These models allow researchers
to study corporate income tax code changes in a manner similar to
the way that they study individual income tax policies. Below
are the strengths and weaknesses of public financial
records:

Strengths: Contains
an enormous amount of financial accounting data.

Weaknesses: Contains
very little corporate tax return data and virtually no social,
demographic, or income data on business owners.

The Leading Policy
Issues

These datasets
provide limited, though important, opportunities for research
about the relationship between entrepreneurial activity and
federal tax policy. Among these opportunities are analyses of the
tax policy effects on how entrepreneurial businesses are organized,
the role that tax policy plays in changing the capital costs that
entrepreneurs face, and how tax policy shapes the savings
behavior and choices of entrepreneurs.

One of the
best-known effects of tax policy is the influence that it exerts in
the choice of organizational form. Entrepreneurs who require
the legal protections and large-scale operating advantages of a
corporate business organization can choose from a variety of
corporate organizations. As shown in the following section,
entrepreneurs and business managers have exercised these choices as
tax rate differences emerge between different forms of
organization.

The level and type
of entrepreneurial activity is often affected by the cost of
capital. That is, indirect and direct taxes on capital can
raise the cost of capital to borrowers above the economic cost that
lenders require to compensate them for the temporary loss of
the funds and the risk of investment. These higher costs can raise
substantial barriers to startups and expanding businesses that lack
the cash flows or credit ratings required to borrow expensive
capital.

Differentials in
capital costs that stem from differences in tax rates can also
produce challenges for entrepreneurs. Falling tax rates are always
welcome news to entrepreneurs. However, capital goods (e.g.,
drill presses, computers, and transportation equipment) placed
in production with highly taxed capital take longer to pay off than
the same goods taxed at lower rates. Thus, older manufacturing
firms are generally less profitable than newer ones from the
standpoint of the after-tax productivity of their
equipment.

Just as differences
in tax rates can distort the value of otherwise identical
equipment, they can also heavily influence the life and future of
existing firms. Estate or death taxes have a particularly striking
influence on entry and exit decisions. For example, small business
entrepreneurship is the common choice of new immigrants,
minorities, women reentering the workforce, and retired people
needing extra income. In each case, success could mean paying
estate taxes that approach 50 percent. Indeed, women, immigrants,
and minority business owners have frequently cited federal
estate taxes as a major factor in their decision to expand and
continue.[11]

There are
doubtlessly many challenges that entrepreneurs face because of the
current set of federal tax policies. However, those described above
offer promising opportunities for breakthrough research in the
policy research field of the interplay between taxes and
entrepreneurship.

Picking Winners and
Losers Is Counterproductive

Many policymakers
favor "targeting" tax relief to certain types of businesses to
promote growth in what they view as "key" industries. Of course,
this sort of policy begs at least two questions: Why not help other
types of businesses? Which types of businesses should be helped?
Favoring any particular industry over another is the wrong approach
because it makes reforming the tax code more difficult, distorts
market incentives, and leads to an inefficient allocation of
resources.

For example, when
business owners make decisions based solely on tax credits,
they spend money on goods that they otherwise would not have
purchased. These purchases may appear to boost the economy, but
they have hidden consequences. If a technology tax credit
causes business owner A to buy a new computer from business owner
B, business owner B will happily make the new sale, but what about
the owner of a non-technology-related store?

The net economic
gain from any money spent on new computers will be at least
partially offset by the money not spent on other goods. This
hidden impact is too easily forgotten, but it is no less real
than the obvious impact from improved incentives in the computer
market. Additionally, these types of targeted incentives make
reforming the tax code more difficult because they create
constituencies that will lobby to keep special tax
advantages.

For example, the
recently passed American Jobs Creation Act of 2004 (H.R. 4520)
includes at least eight separate provisions dealing with
depreciation rules. One of these provisions extends "bonus"
depreciation eligibility by one year for certain non-commercial
aircraft put in service before January 1, 2006. Manufacturers of
these aircraft are therefore likely to resist any tax reform
that proposes to eliminate all targeted depreciation rules. Because
so many special provisions already exist within the tax code, even
small steps toward simplifying the code pits winners against
losers-making reform that much more difficult.

Regardless of the
exact nature of a reform plan, researchers should evaluate the plan
by quantifying the expected value of businesses' future tax
benefits-a task that is not easy. Because so many
competing interests are invested in special tax breaks,
removing all business taxes may be the reform policy that best
minimizes this problem. Various tax constituencies would lose some
special benefits under such a reform plan, but the long-term need
for those benefits would be eliminated. Of course, there would be
serious political obstacles to any reform plan that eliminates all
business taxes.

There Is No "Best"
Definition of What Constitutes a Business

One of the many
squabbles in the last election cycle centered on whether to extend
or to rescind President George W. Bush's tax cuts for taxpayers
paying the top marginal tax rate. An argument against rescinding
these cuts was that many small business owners would be hurt
because they pay individual income taxes at the top marginal tax
rate. Curiously, part of this policy debate centered on which
business owners were operating "real" businesses.

Business income from
a wide variety of business types can show up on individual
income tax returns. For instance, a group of doctors could organize
a partnership to buy a beach house in Florida. If they
periodically rent the house to tourists, the doctors will end
up with partnership income on their individual tax returns. On
the other hand, someone might organize a construction company
as an S corporation and be actively involved in performing physical
labor. Advocates of rescinding recent tax cuts argue that only
the second of these two examples should be considered a
business.

Yet why are both
examples not legitimate businesses? In both cases, individuals have
organized to better invest their money and use their resources.
Both businesses will buy products and, either directly or
indirectly, employ other people. In fact, the construction company
may even perform services for the partnership. Each of these
individuals is undertaking legitimate productive activities that
benefit others. Disparaging either legal entity as "not a real
business" ignores this fact. The debate about the "real" business
owners also took on a class warfare theme, with tax cut opponents
arguing for raising taxes on "wealthy" business owners.

Income Is a Fleeting
Concept in the IRS Data

Supporters and
critics of the Bush Administration's tax policy label
taxpayers earning more than $200,000 as "the wealthy," as if
this were an easily identifiable group of taxpayers. This notion is
problematic because the definition of income is not
straightforward and because identifying taxpayers in any given
year-for any purpose- ignores long-term trends.

To begin, tax policy
researchers typically define income as adjusted gross income
(AGI) because it provides a common point of comparison. However,
AGI is a special IRS definition of income, and it accounts for up
to 18 types of income. Just as important, AGI is calculated after
any number of deductions: Form 1040 lists 10 deductions, and all
business income from pass-through entities is reported
after business expenses have been deducted. Even granting
that AGI is the best measure of income, choosing a level of
$200,000 as the cutoff point for tax breaks is completely arbitrary
and is no better or worse than $175,000 or $225,000.

Furthermore, IRS
data are reported on an annual basis, obscuring information that
could be learned by following taxpayers' income over a number
of years. For instance, the number of business owners who typically
earn AGI above $200,000 could be understated in any given year
simply because of unusually high business expenses. Even conceding
that the number of taxpayers with more than $200,000 in AGI for any
given year is the true number of such taxpayers, the number of
taxpayers in this category can change in future years simply
because a new law eliminates certain deductions.

If multiple legal
changes are made during several years, the number of taxpayers
in a given AGI class could change for reasons unrelated to
economic activity. Regardless of how "income" and "business"
are defined, tax policy that singles out any group for higher taxes
hurts all taxpayers. This rule holds true for owners of both large
and small businesses, even though large corporations are
frequently vilified for political reasons.

Large Businesses
Were Not Always Large

Treating owners of
both small and large businesses the same will certainly be
criticized as "pandering to corporate America," and ignoring
the "little guy." However, championing small business owners while
simultaneously disparaging owners of large businesses is
contradictory. Owners of large businesses start out by owning small
businesses. People are not born owning businesses: They choose
to start companies at some point in their lives based on their
experiences.

Tax policies that
intrude on the decision to start a business-or on decisions made
while running a business of any size-distort decisions that would
be made in the absence of these policies. Therefore, an
economically neutral tax policy is one that does not discourage
potential business owners, small business owners, or large business
owners from making economic decisions. In other words, the best tax
policy affects all business owners the same.

Taxing income only
at the individual level would be a significant departure from the
current tax code, but the idea is based on a simple premise:
Corporations do not pay taxes-people do. Corporations of all
sizes are merely legal entities. They are all run by people
and they all sell goods and services to people. Ultimately, all
corporate taxes are taken out of the pockets of people, either
through lower compensation to workers or higher prices paid by
consumers. Historical data on new-business formation suggests that
more and more business owners understand this concept quite
well.

Most New Business
Owners Organize As Non-Corporate

More and more
business owners are choosing to organize as "pass-through"
entities, such as S corporations and limited liability
companies. These "non-corporate" forms afford legal protection
similar to that of traditional corporations, but they allow
business income to pass through to the owners' personal tax
returns. Consequently, pass-through entity owners' business
income is taxed only at the individual level, whereas owners'
income from a traditional C corporation is taxed at both the
corporate and personal level. Historical data show
increasing trends in the number of non-corporate entities, and the
owners of these businesses continue to pay taxes on their
business income-just not through the corporate tax
system.

Chart 1 shows the
trend in the number of S and C corporation filings from 1975
through 2004.[12] In 1975, S corporations accounted for
only 17.22 percent of the total returns, while C corporations
accounted for more than 80 percent. However, by 1996, S
corporation returns accounted for the majority of the total. The
IRS projects that S corporation returns will account for nearly 60
percent of these business tax returns in 2004.[13] Table 1
demonstrates that there has been substantial growth in filings for
other types of pass-through entities as well.

Both sole-proprietor
and partnership (including LLC) filings have more than doubled from
1975 to 2004. During this same time period, traditional C
corporation filings increased by only 23 percent. Table 1 also
provides a more recent comparison that shows that the number of C
corporation filings actually declined from 1990 to 2004. In
contrast, the growth in all three categories of pass-through
entity filings increased substantially from 1990 to
2004.

The number of sole
proprietors-defined as individuals filing an IRS Schedule C,
C-EZ, or F- increased by 28 percent from 1990 to 2004, while
partnership returns increased almost 42 percent.[14] During this same
time period, the number of S corporation filings increased 127
percent, while C corporation filings decreased 7 percent.
Given the enormous relative growth in the pass-through entities
since 1990, the distinction between corporate and individual taxes
is much less meaningful than it was only 25 years ago.
Consequently, business-related tax policies have to
account for provisions in the individual income tax code.
Statistics about the level of business activity that these
non-corporate entities contribute to U.S. economy further
support this notion.

Statistics About
"Non-Corporate" Businesses

There is no perfect
measure of how important any group of businesses is to the U.S.
economy, but there are some basic figures that provide insight
into this inquiry. Table 2 summarizes the total amount of wages
paid by pass-through entity businesses in 2001. These data
show that S corporations, partnerships, and sole
proprietorships paid out roughly $665 billion in wages.[15]
This figure probably understates total wages paid out by these
entities, because not all S corporations and partnerships are
required to submit financial statements to the IRS.
Nonetheless, this $665 billion in wages represents almost 20
percent of all private wages in the U.S.[16]

Of course, wages are
not the only measure of how important businesses are to the U.S.
economy. Charts 2, 3, and 4 demonstrate that owners of pass-through
entities operate in a wide array of industries, ranging from real
estate and health care to construction and financial services.
Just as important, the financial records of each entity group show
that these businesses rely on multiple sources of
income.

Across industries,
these businesses derive significant amounts of income from
sources such as financial market investments and investments
in other businesses. (See Tables 3 and 4.) These relationships
suggest that over-burdening any particular industry with higher
taxes (relative to other industries) would be felt by all
types of business owners and their customers. A similar case can be
made for owners and customers of corporate entities.

Statistics About
"Corporate" Entities

A majority of the
economic activity in the U.S. takes place through publicly traded
corporations. However, as with non-corporate businesses, there is
no perfect measure of this activity. Table 5 summarizes
several financial accounting measures taken from Standard and
Poor's Research Insight database. These figures are from 2002 and
were reported by all companies (in the database) with total assets
greater than $175 million.[17]

This group of
corporations reported total (book value) assets of about $46
trillion, from which approximately $14.6 trillion in net sales was
generated. These companies reported $933 billion in capital
expenditures; more than $2 trillion in selling, general, and
administrative (SG&A) expenses; and $9.9 trillion in "cost of
goods sold."

Publicly disclosed
financial statements also provide measures of income generated
for shareholders. For example, the amount of cash dividends
these companies paid to shareholders in 2002 was more than $304
billion.[18]

Another measure
worth examining is free cash flow, a measure that represents the
cash left over after all dividends, expenses, and capital
expenditures are deducted. These firms reported a free cash
flow of almost $520 billion in 2002. Although this number is quite
large, it represents only 4.35 percent of the companies' combined
cost of goods sold and SG&A.

These figures do not
support the notion that large corporations have huge economic
profits and can therefore easily absorb tax increases.
Furthermore, neither the size of these companies nor their
form of legal organization changes the fact that they are only
legal entities. These organizations, just as the pass-through
entities discussed above, are run by people and sell goods and
services to people. Taxing either type of entity ultimately
places an additional financial burden on people. (See Table
5.)

Conclusion

Throughout most of
U.S. history, governments at all levels have primarily strived
to establish a rich and stable institutional setting for
entrepreneurship numerous and open courts for adjudicating
legal problems, a banking system with safeguards and flexibility,
tariff-free movement of goods and labor across state borders, and
so forth. Although major exceptions exist, the grand drift of
American history places the individual as the actor in a
marketplace that states protect but do not shape
financially.

That relationship
between government and entrepreneurs fundamentally changed in
the 20th century, particularly after World War II. The federal
and state governments used many policy handles in their retreat
from laissez faire economic policies, but the federal
tax code stands out as the most powerful of all of the tools.
Markets, costs, economic incentives, and even whole categories of
goods and services were changed by the way the federal
government taxed enterprises.

Given that
influence, it is surprising how little attention has been paid to
the relationship between entrepreneurship (at all levels) and
federal tax policy. As this paper indicates, numerous
databases could-and do-support research into this relationship, and
the policy issues they could inform touch on some of the most
important topics in tax economics. Research on these issues
promises to produce insights that could well shape tax policies in
order to strengthen entrepreneurship and economic
activity.

[1]For a rigorous
treatment of this issue, see David Storey, "Six Steps to Heaven:
Evaluating the Impact of Public Policies to Support Small
Businesses in Developed Economies," in Donald L. Sexton and Hans
Landstrom, eds., Blackwell Handbook of Entrepreneurship
(Oxford: Blackwell, 2000), pp. 176-193.